A 2013 Bond Market Prognostication: Why a Breakout Appears Likely

Plus: What are the levels to watch next year?

I think 143-00 is a huge number. It was a climax top in 2008. It was made support in 2011 and 2012, and it's very close to two standard deviations in the rising channel. If violated to the downside, a bond market top could be in place, but don't expect it to go quietly; it will likely put up a tough fight.

On the upside, you obviously have 150-00, which has proven to be a big pivot but also you have to recognize the presence of the dead Italian. If the market can make 150-00 support, there could very well be an attempt to test the upper end of channel. The next Fibonacci stops are the 1.382% at 154-16, the 1.50% to 158-00, and finally, the big 1.682% extension all the way up to 161-16.

What Is the More Likely Scenario?

I give no edge to either move, but I will say that in 2013 I expect a significant shake out in the equity market. I am not looking for a crash, but I think there is more work to be done to the downside in this ongoing bear market, and next year could very well see another leg lower. This is not a hunch but based on credit market metrics that I follow, which are pointing to a material decline in the demand for money; this has historically forecasted a re-pricing of risk premiums. If I am correct, odds would shift toward the bond market testing the upper end of the channel and some of the higher Fibonacci extension levels.

On the flipside, the initial reaction to the latest Fed policy move that I deemed a de facto nominal GDP target last week has been toward wider inflation premiums and higher yields that have manifested in a steeper curve.

Bernanke has put himself between a rock and a hard place. He can't come out and say that he wants to reach a nominal GDP number of 19.6 trillion by 2015, or worse, that he needs the growth rate to be 7.0% in order to close the output gap. The bond market would crash. But the market is not stupid. The longer he attempts to hold bond yields below the rate of inflation while at the same time trying to stimulate the inflation that erodes these same coupons, the more worthless they become and the more interest rate risk he generates. It seems at some point Bernanke will be facing a Pyrrhic victory. If he is successful, eventually the curve will unwind and the bond market will crash.

If the Fed is successful in reflating the economy in 2013, the Pyrrhic victory could be a real scenario and if it gets traction the market could be under significant pressure and the lower objectives would be in play. Because of the technical nature of the rising channel and important 143-00 level I think on balance there is less margin for error and thus more risk on the downside.

Nevertheless, this is the time to leave your bias at the door. The bond market has been consolidating a relatively tight range for six months and has lulled many participants to sleep. I think this thing is wound up and ready to break out. It's unlikely that we will be sitting in this same spot next year; which way we go and where we end up is going to have wide-ranging ramifications for the asset markets and implications for the economy.